Barry Bannister, Stifel's head of institutional equity strategy, says the fed funds rate is too high relative to the neutral rate, a theoretical level at which the Fed is neither restrictive nor accommodative.

Monetary policy that is too tight could hinder U.S. economic growth and even spark a recession.

"Rates signal a bear market, and Fed hesitations risk a repeat of Custer's last stand at Little Big Horn," wrote Bannister.

Jerome Powell, chairman of the U.S. Federal Reserve, speaks during a news conference following a Federal Open Market Committee (FOMC) meeting in Washington, D.C., on Wednesday, July 31, 2019.

Andrew Harrer | Bloomberg | Getty Images

The next recession in the U.S. could be triggered by still-restrictive Federal Reserve policy unless the central bank makes a committed and sustained effort to lower interest rates, Stifel's Barry Bannister says.

Bannister, the firm's head of institutional equity strategy, wrote in a note Thursday that the fed funds rate is too high relative to the neutral rate, the theoretical level at which policy neither fuels nor inhibits economic growth. Monetary policy that is too tight could hinder U.S. economic growth and even spark a recession. The Fed's target rate range is between 2% and 2.25% after a cut of 25 basis points in July.

Recession fears have risen recently amid warnings from the bond market while the U.S.-China trade war rages on. This has led to a sharp rise in stock market volatility over the past month.

"Rates signal a bear market, and Fed hesitations risk a repeat of Custer's last stand at Little Big Horn," Bannister wrote, referring to the 1876 battle between U.S. forces led by Gen. George Custer and several Native American tribes. "The Fed should quickly go below neutral, since crises occur at progressively lower 'spreads' to neutral."

The 10-year Treasury note yield is currently trading below its 3-month counterpart. This is a phenomenon called a yield-curve inversion. Experts fear when the yield curve inverts because it has historically been followed by a recession.

Bannister points out that the 50-day moving average, a technical level watched by traders and strategists, for the 10-year-3-month yield curve also inverted in late June. In the past 50 years, this has preceded a recession by an average of 10.5 months "with no false recession signals." Stocks typically don't do well in recessions.

The S&P 500 averages a loss of 32% when the U.S. economy enters a recession, Bannister said. A 32% drop from Wednesday's close of 2,887.94 would take the S&P 500 down to 1,963.78.

Recession fears, along with worries over the trade war, have already taken their toll on stocks. The S&P 500 is down more than 3% over the past month.

To be sure, the U.S. economy is still growing at a solid pace. The economy expanded by 2% in the second quarter while consumer confidence remains near its highest level since 2000. Also, some experts think the yield-curve inversion is a byproduct of easier monetary policy abroad. The European Central Bank and the People's Bank of China, for example, have pointed to more monetary stimulus moving forward.

The Fed 'must quickly cut'

The Fed raised rates four times in 2018, with the last one sparking a massive stock sell-off in December. Changes in Fed monetary policy heavily influence Treasury yields, particularly along the short end of the yield curve. The longer end of the curve — 10-year note and 30-year bond rates, for example — are more subjected to conditions in the open market.

"In 4Q18, the Fed vastly over-shot and must quickly cut or a major bear market may result," Bannister wrote.

Easier monetary policy measures, such as rate cuts, could steepen the yield curve and would bring the fed funds rate back below the neutral level. However, the Fed needs to be aggressive when cutting rates, Bannister said.

Even if the Fed cuts rates by another 25 basis points in September, as is widely expected, "policy would still be too tight," said Bannister, whose recent market calls, including the 10% correction in early 2018, have panned out.

"Having reached neutral in 4Q18 and pressuring the market, time is running out for the Fed to cut," he wrote.